Net Profit Margin

What is Net Profit Margin?

Net Profit Margin (or simply “Profit Margin”) is a ratio used to calculate the percentage of profit a company produces from its total revenue. The profit margin is equal to net income divided by total revenue, expressed as a percentage.

The profit margin ratio of each company could be different depending on which industry the company presents. As a financial analyst, it’s important in day-to-day analysis.

Net Profit Margin Formula

Net Profit margin = Net income ⁄ Total revenue x 100

Net income is calculated by subtracting all company expenses from its total revenue. The result of the profit margin calculation is a percentage – a 10% profit margin means for each $1 of revenue the company earns $0.10 in net income. Revenue is the total sales of the company.

Understanding the Net Profit Margin Ratio

The profit margin ratio is used to describe a company’s ability to produce profit and to consider several scenarios like an increase in expenses, which are deemed ineffective, and used extensively in financial modeling and company valuation.

A single number in a company report is rarely adequate to point out overall company performance; an increase in revenue might translate to a loss if followed by an increase in expense. On the other hand, a decrease in revenue, followed by tight control over expenses, might put the company in profit.

A high net profit margin means that a company is able to effectively control its costs and/or provide goods or services at a price significantly higher than its costs. Therefore, a high net profit margin can result from:

Investors need to take numbers from the profit margin ratio as an overall image of company profitability performance and initiate deeper research on the cause of an increase or decrease in the profitability as needed.

Limitations of Net Profit Margin Ratio

When calculating the net profit margin ratio, analysts commonly compare the different companies’ ratios to determine which company performs the best.

While this is common practice, the net profit margin ratio could greatly differ between companies in different industries. For example, companies in an automotive industry may report a high profit margin ratio but lower revenue compared to a company in the food industry. A company in the food industry may show a lower profit margin ratio, but higher revenue.

It is recommended to compare only companies in the same sector with similar business models.

Other limitations include the possibility of misinterpreting the net profit margin ratio and cash flow figures. A low net profit margin does not always indicate a poorly performing company. Also, a high net profit margin does not necessarily translate to high cash flows.

Financial Analysis

Calculating the net profit margin of a business is a routine part of financial analysis. It is part of a type of analysis known as vertical analysis, which takes every line item on the income statement and divides it into revenue. To compare the margin for a company on a year-over-year (YoY) basis, a horizontal analysis is performed. To learn more, read CFI’s free guide to analyzing financial statements.

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